The world’s banking system and the value of publicly traded shares on capital markets are roughly similar in size: both in the order of $100 trillion worth of assets. But the future may require capital markets to shoulder much more of the responsibility for investment and growth.
A recent paper from the World Federation of Exchanges (WFE) examines why equity capital markets are well placed to do that and why public policy should encourage it, in light of the distinct and positive risk-reward profile of capital market-based finance. Market-based finance and credit channels play distinct and complementary roles in supporting economic growth, acting as twin engines, and that regulatory and other policy could do more to respect that distinction, as present policy shows signs of confusing the two.
A key part of the paper’s purpose is to look at the nature of short-run risk, contrasting it with concerns about systemic stability that can arise in the credit world. WFE challenges the idea of applying prudential rules to markets that are only appropriate to credit and banking channels. In credit channels, risks can easily become systemic in nature and require measures such as capital rules. In market-based finance, this is the rare and manageable exception, and in all other cases the wrong type of rules are not just unnecessary but damaging.
False equivalence between the two very different forms of finance has already led to perverse outcomes, including the LDI crisis of 2022. It threatens the operation of the collective investment schemes through which most people have access to long-term returns.
Share markets have performed well over time and through recent turmoil, such as the pandemic. In 2020, these markets were resilient in both new issuance and the ability to continue to buy and sell stakes in companies as the economy continued to evolve.
Market-based finance includes bonds – which bring a further dimension to investor possibilities while avoiding some of the opacity of credit markets – and derivatives, which bring the flexibility to fine-tune risk profiles over horizons chosen by investors, whether individuals or collective asset managers. But shares remain the key to financing the future.
Laurits Bach Sørensen, partner and co-founder of northern European growth fund Nordic Alpha Partners said in the paper: “It will cost €28 trillion [$29.8tn] for Europe to reach NetZero by 2050. Roughly half needs to be driven by market financing. Hence, if we don’t get public market financing in place to substantially support across EU, the EU will struggle to reach and lead the green transition in a cost-effective and competitive way.”
Nandini Sukumar, CEO at the WFE, said in a statement: “Both credit markets and share markets have a place in the financial system and are needed for different financing requirements. To enable share markets to deliver their potential in funding future growth opportunities (including net zero transition), the appropriate policy support is required.”
Richard Metcalfe, head of Regulatory Affairs at the WFE, said in a statement: “The WFE believes that a clear and coherent risk-reward analysis should lie at the heart of public policy towards all forms of finance. It is wrong and counterproductive to take the risk-reward characteristics of one part of the financial system and apply it to another part, whose different profile makes the system safer and sounder.”